Lower rates, no recession
Navigating through all the noise out there, it seems the most sensible expectation that investors should have is described by “lower rates but no recession”. Central banks were more dovish again this week and the Fed looks as though it is ready to meet markets expectations on cutting rates. There are risks to growth from a range of things, but we shouldn’t underestimate the power of the easier monetary policy message. That’s why I like being exposed to long dated government bonds and to shorter-dated credit. Things could go wrong, obviously, and active investors might need to be ready to change their stance. The other thing not to underestimate is the importance of technicals in the bond market. The availability of non-central bank owned positively yielding assets relative to the demand for fixed income is the key supportive factor for bonds. They look expensive, they have had great returns so far, but a bond sell-off of any size looks very remote.
Lower growth, lower rates
The markets were very focussed on central banks this week and although there was no change in actual policy from either the Federal Reserve (Fed), the European Central Bank (ECB), or the Bank of England (BoE), the message was clear. Central bankers are very sensitive to downside risks to the economic outlook and to the profile of inflation and are ready to ease policy again should these risks begin to materialise in any way. Risky assets liked that message. The S&P closed at a record high on Thursday 20th June (and to reinforce the point, President Trump tweeted it) while credit spreads have continued to decline. The combination of lower government bond yields and narrower credit spreads has boosted fixed income returns this month with European corporate credit up 1.4%, US high yield up 2.3%, and emerging market external debt up 3.7%. My interpretation is that the macro view driving markets is that the anticipated easing of monetary policy will be enough to head of a global recession. A modest slowdown and lower financing costs are supportive for credit markets.
However, the week also reminded us of the risks that investors will and should be concerned about. Tensions between the US and Iran reared up. In the UK, Conservative MPs have put Boris Johnson in pole position to become the next Prime Minister. His campaign has been defined by his promise to take the UK out of the European Union on October 31st with or without a deal. Many informed observers will argue that there is no easy way of doing that. Theresa May tried three times to get her negotiated Withdrawal Agreement through Parliament, without success. The message from the EU is that there is no scope for renegotiation. Either “no Brexit”, an “extension”, or “no-deal” seem to be the options on the table and, as has been the case for the last three years, the probability of either of these becoming reality is not easily determined. Meanwhile, UK economic data continues to reveal that confidence is very much under pressure. The Confederation of British Industry said last week that its June manufacturing order book index hit the lowest level since 2016 when there was a global manufacturing slump. As we approach the G20 meeting in Osaka next weekend, we are all aware that the US and China have yet to reach a deal that would allow for the rolling back of tariffs that have been imposed on Chinese exports. The risk of no-deal or an escalation of trade conflicts remains a key risk.
Fed to deliver it seems
Interest rate markets have got 100 basis points (bps) of US easing priced in before the end of 2020. I looked back at previous interest rate cycles in the US and look to what happened relative to what is priced in today. In 1995-96 the Fed did ease by 100 bps – a textbook mid-cycle insurance easing policy. However, every other time the easing cycle was much more pronounced and happened much more quickly than what is priced in today. I guess that what stands out about this cycle is that there are no obvious financial imbalances. In 1990 we had the US banking crisis, in 2000 it was the bursting of the dot.com boom, and in 2008 it was the denouement of the credit boom. Today there are some concerns about the leveraged loan market, but in the public bond markets the creep lower in financing costs have helped contain financial leverage. For traditional higher credit risk sectors this has been a powerfully positive dynamic as the trend is for new borrowing to be done at lower coupons, thus reducing the overall financing costs for companies. By the way, Italy is also benefitting from reduced borrowing costs which will partially offset the concerns around its fiscal position. The absence of large scale financial imbalances and easier monetary policies mean that two of the typical drivers of a recession are not in place. So, the rate cuts priced in might be all that is needed.
Lots of momentum
If that is the case then it is hard for bond yields to go even lower than they are today. However, that is a call I am not willing to make now. Why is that? Well, for one thing there is a lot of uncertainty in the outlook and the political risks that can impinge on the economy are not going away. The Fed will need to satisfy what the market has already got priced in and will be under pressure to do so, especially with the ECB moving towards an easier stance. Secondly, the Fed now thinks that the long-term equilibrium Fed Funds rate is 2.5%. So, the actual Fed Funds rate is now at the long-run neutral rate. If the economic growth rate is under pressure and the Fed wants to avoid an increase in unemployment, then it must cut rates to get back to an easier monetary position relative to neutrality. The “real Fed funds” rate is positive in the US but are -100 bps in the Euro Area and the UK. A 100 bps cut in rates, assuming no change in the level of inflation, will still leave the Fed with the higher real rates. Thirdly, are the very strong technical in the bond markets everywhere. People need bonds and there aren’t enough. Central banks own a huge amount. A record nominal amount is now trading with negative yields. That leaves the universe of positively yielding bonds that are not owned by central banks and other price insensitive investors lower than it has ever been relative to the potential demand for fixed income. And why do people want fixed income? There is a need for income and for diversification. Which is why German long-term bond yields are still falling, why spreads in European sovereign credit markets have continued to move lower, and why higher beta credit markets have performed well even with concerns about slower growth and political risk. French 30-year bond yields are currently at 98 bps. That seems so low for such a long-dated asset. Yet this is 70 bps above the equivalent German bond and almost 130 bps above the ECB’s deposit rate (which might go even lower). Given its duration, another 25 bps decline in the yield will deliver 6% capital gains. I can’t stress enough that investors need to get over the optically low level of yield in bond markets today. Yield does not equal return. The momentum is very strong, Draghi has promised additional easing and lower yields are forcing convexity sensitive investors to keep buying longer and longer duration. My personal target is for US Treasury yields down to 1.6% in the next few months and the Bund to get close to the current level of the ECB’s deposit rate as a re-ignition of quantitative easing becomes a key market expectation.
Comfortable with risk
Lower core rates and bond yields is consistent with risk assets still performing. Corporate earnings expectations have come down but there is no collapse. Most economies are still doing alright given strong employment growth and consumer spending in recent years. Yes, there is ongoing disruption – look at the auto and retail sectors – but there continues to be growth in jobs elsewhere. Meanwhile there is scope for fiscal policy to be more proactive in many economies. So, I like strategy of having long duration assets alongside higher yielding more credit sensitive assets. Of course, the uncertainty in the outlook will remain and keep investors nervous – Iran, Italy, North Korea, US-China, and Brexit. But we’ve lived with these risks for some time now and the most important thing is the Fed put. Markets are up, economies are growing and there is no risk from an inflation or interest rate shock.
Does valuation matter?
The one warning I would highlight from our recent review of the market outlook across the fixed income universe is valuation. There was a clear valuation case for adding to credit in December but the case is much less persuasive today, whether we are looking at outright yields or credit spreads. On any long-term chart, government bonds look super expensive and we expect that they will get even more expensive. At some point valuations will become an issue. However, that will need some change in the environment. Growth optimism will need to improve, inflation expectations will need to rise, and some of the political risks will need to fade. The 40-year bull market in interest rates has been punctuated by many calls for bonds being overvalued, and I am guilty of having fallen into that trap at times. The combination of forces such as demographics and digitalisation has made economies less inflationary while at the same time we find it difficult to show that there has not been a long-term decline in productivity. As such, real interest rates are lower, and it will take a lot to generate inflation in economies that are not as capacity constrained as traditional measures like the unemployment rate would suggest. The end of lower rates is not here yet.